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Analysis of Accounting Ratio

Updated on March 31, 2013
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Definition

A ratio is a number expressed in terms of another number. its a statistical yardstick a measure of the relationship between two figures. It is an expression spelt out by dividing one figure with the other. For example, a business has current assets of $. 5,014.000 and current liabilities of $ 2,000,0000 on a particular date.then the resulting ratio would be $ 5,014,000/2,000,000=2.57

Hence, a ratio is simply the quotient of two numbers. It is almost meaningless by itself. an accounting ratio must be interpreted against some standard to impute meaning . we can compare a present ratio with the past as well as expected future ratio for the same company

The second method of comparison involves comparing the ratio of one company with those of similar companies at the same point of time.


kind of ratios

The need for the accounting ratios arises because absolute figures are often misleading No. doubt, they are certainly valuable but there value increases manifold if they are studied with other ratios.They enable the mass of date to be summarised and simplified or presentation to management for studying trends an making comparative statement, of performance and stability of business .for example . If sales have been increased from $ 1 Million to 1.5 Million . it may not be as favourable as it is the same might have been on account of disproportionate rise in expenses or due to increase in selling price. Hence an overall appraisal of the company's business depends upon the different accounting ratios drawn on the basis of various records.

it is clear that ratio analysis is an instrument for diagnosis of the financial health of an enterprise. it is an invaluable aid to management in the discharge of its basic functions of forecasting , planning , Co- Ordination control and communication Ratio analysis helps in predicting and projecting the future by analytical study of the past performance of the business.

Accounting ratios may be broadly classified as follows:

1. Balance Sheet Ratios

When Ratios is between two balance sheet items it s called Balance sheet Ratio or financial ratio.

2. Profit and Loss Ratios

When a ratio is between two P & L account items is is called Profit and Loss account ratio or operating ratio.

3. Composite Ratios

When a ratio is between Balance sheet item and profit and loss account item. it is called composite Ratio'

When Ratios is between two balance sheet items it s called Balance sheet Ratio of Financial Ratio.when a ratio is between two P& L Account items it is called '


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Advantages

1. Accounting ratios are most commonly used for management control purposes by comparing its own performance with the performance of other similar concerns

2.It is one of the media link to the past and future .

3. They can play a significant role in cost accounting financial accounting .budgetary control and auditing.

4. Apart from management it assists the general public to understand the financial trend and financial health of the business. It is possible from ratio analysis. to have a general impression of the past performance of the business and is possible to have a forecast about the uncertain future without any difficulty.

5. Identification of financial responsibility is possible from critical analysis

6. Ratio analysis is one of the factors which curb the development of institution in financial management .

However it is questioned whether accounting ratios will render valuable services to all concerned it all depends on the person who handles it.


Limitations

Accounting ratios have the following limitations:-.

1. The ratio thus drawn are based on the historical figures appearing in the Balance Sheet.

Hence the performance of one enterprise based on the historical data gives a wrong direction to the approach.

2. assets and liabilities are not grouped under money value and real value items in preparing different ratios.

3.One particular ratio is not sufficient to review the operation of the business. it should be considered along with other related ratios.

4. Accounting and financial ratios will tend to interpret wrong direction , If based on unauthentic data .

5. Accounting ratios, in practise are useful to understand the bend of particular unit not particular type of business as a whole. this can be done by comparing the past results with flat of the present management and financial polices which differ widely from concern to concern . But in practise it is difficult to compare the performance of one company with the other.The study of ratio analysis gives us some guideline, because, a ratio which is satisfactory for one particular enterprise may reverse in the case of another

From the points discussed above it can be stated that ratio analysis can be regarded only as an aid to making judgement and not a substitute to judgement.






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